Marathon Oil (MRO) became a fully focused upstream business in 2011. This followed the spin-off of the refining and downstream operations which are now known as Marathon Petroleum (MPC). Investors in the downstream business have seen the value of their holding nearly double over the past five years despite a 40% pullback from 2015 highs.
This move stands in sharp contradiction to the 50% fall which investors in Marathon Oil have seen, even as shares have more than doubled from the lows in February of this year. A heavy debt load, lossmaking oil operations and the lack of the diversification brought by the downstream business, has created a storm which has been very painful for its shareholders.
The company has been active to shore up its balance sheet with an equity issuance, asset divestitures, but last week it announced a surprising asset purchase. While the investment community applauded the deal, I have some serious concerns. This does not relate directly to this deal itself, but mostly to poor asset allocation.
Sooner Or Later An "Idiot" Runs The Business
Warren Buffett once said, "I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." While I would certainly not argue that Marathon´s managers are idiots, some past decisions raise eyebrows to say the least. Of course, I am drawing this conclusion with the benefit of hindsight, after oil prices have seen an almost historic collapse.
There is a reason why consistent businesses outperform cyclical and commodity plays. Companies that enjoy little pricing power or rely on commodity prices can report huge losses during downturns. This can lead to severe dilution at best, or bankruptcy at worst, in many cases. Dilution can take place in the form of new shares to be issued, or by significant asset sales at relative low prices.
I would argue that in commodity related industries the capital allocation task of management is actually far more important than squeezing a small percentage improvement in terms of operating metrics.
Since the spin-of in 2011, Marathon Oil lost a great deal of business diversification, which theoretically implies that it should be much more cautious with leverage. This is certainly the case as the company embarked on a transformation strategy. It divested assets abroad in places like Angola and Norway, fetching billions in the process. Most of these proceeds were used for shareholder `friendly` initiatives as well as investments in US unconventional plays.
This meant that leverage was actually increasing, certainly when oil prices started to fall. Marathon ended 2015 with a net debt load of $6.1 billion, up significantly from the $4.0 billion net leverage position in the year before. When oil prices collapsed to $30 at the start of this year, the company was therefore almost forced into issuing equity in order to raise cash.
The company ended up selling 145 million shares in February of this year at $7.65. This excludes the impact of the greenshoe option. The gross proceeds from this deal were just $1.1 billion. Remember that the company bought back $500 million of shares in 2013, and another $1 billion in 2014. The timing of these purchases is very painful indeed. The $1 billion program in 2014 was sufficient to buy back just 26 million shares. A similar sized program now involves the issuance of 145 million shares, diluting the shareholder base by 21%.
What About Asset Sales?
As oil prices recovered during this spring, in the aftermath of the share issuance, Marathon announced further deleveraging actions. In April it signed a $950 million deal which mainly included upstream and midstream assets in Wyoming. These assets produce 16,500 barrels of oil-equivalent per day, as the deal included the 570 mile Red Butte pipeline as well. The transaction price amounted to $57,000 per barrel of oil-equivalent produced each day, but that is not a fair calculation given the significant midstream activities included in the deal as well.
This deal had the potential to significantly deleverage the balance sheet. Marathon ended the first quarter with $2.1 billion in cash following the equity issuance and $7.3 billion in debt. Including the asset sale, the net debt load is seen at $4.3 billion, excluding roughly half a billion in pension related obligations.
The 825 million diluted shares outstanding value equity of Marathon at $12.4 billion, as long as shares trade around the $15 mark. This gives Marathon a $17 billion enterprise valuation. Based on first quarter production of 388,000 barrels of oil-equivalent per day, this amounts to $45,000 for each barrel being produced each day, or roughly $8 for each of the 2.2 billion barrels in terms of reserves.
Why Buy Already?
The fact remains that Marathon still had a +$4 billion pro-forma net debt load by the end of the first quarter, while it was still losing money. This makes it prudent to remain careful with allocating capital to projects, acquisitions, or shareholder returns, especially given the relative poor track record in doing so.
Despite this knowledge, Marathon announced the purchase of PayRock in June, for a sum of $888 million. Marathon is strongly defending the deal by pointing towards the high quality inventory, low well costs, and 60-80% internal rate of returns at $50 WTI.
I always question the underlying assumptions behind the IRR calculations. These assumptions are typically not disclosed by many energy companies, and they generally exclude taxes as well. Given that taxes are typically very high in the industry, that is not a prudent thing to do. In general, the acquired assets are of a high quality, driven by high percentage of liquids production and low well costs.
2P reserves are seen at 330 million barrels. If we include possible reserves this number increased to 700 million barrels. Development of these assets will result in large future capital investments given that current production comes in at just 9,000 barrels of oil-equivalent per day. This suggests that Marathon is paying $100,000 for each barrel being currently produced per day.
While the purchase price looks appealing at just $2.70 for each barrel in terms of 2P reserves, realize that these are the non-GAAP metrics in terms of reserves. Unfortunately no 1P reserves were released for PayRock, but anecdotal evidence suggests that these reserves are significantly less than 2P reserves.
I Do Not Give Management The Benefit Of The Doubt
I wrote this article not to discuss Marathon based on quality of assets, reserves, production and expense metrics. These are operational factors and combined with the fortune of oil prices, they determine the value of the business.
In a very capital-intensive industry, such as the energy business, capital allocation is just as important, or perhaps more important than these operational achievements. The fact is that Marathon´s management has done a poor job at this. The company bought back stock in 2014 at an average price which was roughly 5 times the price at which it was forced to issue stock at the start of 2016.
If you thought that management has learned its lessons and proceeded to be more cautious with debt, you were initially proven right following asset sales during the spring. The $888 million purchase price of PayRock does not fit that picture, even if it brings a lot of interesting future drilling acreage inventory. The fact of the matter is that the current impact is non-trivial, boosting production by merely 2%.
To put it simply, management has not indicated that they deserve the benefit of the doubt. This makes me very cautious to buy into impressive internal rate of returns stories.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.